AMID THE WELL-HEELED RETIREES WHO PLAY GOLF and walk the beach in Carmel-by-the-Sea, California, economist William Sharpe is hard at work. Professor emeritus at Stanford University and winner of a 1990 Nobel Prize, the 78-year-old Sharpe is deeply immersed in the study of “retirement economics.” He’s tackling the knotty question of how growing ranks of retirees — especially the gray brigade of baby boomers — can live off their savings as they reach ages unimaginable to earlier generations.
Sharpe’s work is crucial to financial firms racing to serve investors who hope somehow to fund their golden years. From 1970 to 2007 the retired lifetime of an American male increased by 34 percent, according to a paper published by Amy Kessler, head of longevity reinsurance at Prudential Retirement, in Longevity Risk Management for Institutional Investors, an Institutional Investor journal. American males now live an average of 17.5 years once they hit age 65, compared with 13 in 1970. Women survive almost 20 more years, up from 15 in 1970.
“I’m trying to understand the properties of different schemes for investing and spending and annuitizing in retirement,” says Sharpe in a phone interview from his home. “And there are zillions of them. Every part of the industry, from insurers to mutual funds to advisers, are all coming up with magic formulas, magic investment strategies. But there are no simple answers. It’s a difficult and complex problem.”
Sharpe and his compatriots studying retirement economics begin with some sobering math: U.S. corporate pension plans face a $689 billion deficit, while public plans in the U.S. are underfunded by about $4.4 trillion, according to a 2012 study by Harvard University’s John F. Kennedy School of Government. Individuals saving on their own fall woefully short of what they need as well — some $4.3 trillion short, according to an estimate by the Washington-based Employee Benefit Research Institute. EBRI’s 2012 Retirement Security Projection Model analyzed retirement income for baby boomers born between 1948 and 1964 (though the generation is usually defined as the 1946–’64 age cohort), and Gen Xers, born between 1964 and 1974. In an analysis for Institutional Investor, EBRI research director Jack VanDerhei concluded that an increase in longevity of just two years would push up his estimate of the shortfall to almost $5 trillion.
Those trillions add up: Institutional and individual investors need to save, and plow into the markets, $9.4 trillion more than they have so far. As a point of comparison, assets in U.S. mutual funds total $13 trillion.
If even a portion of that nearly $10 trillion in future retirement assets moves into markets, it could dramatically redirect global capital flows, changing economic incentives for both issuing and managing securities and possibly distorting whole sectors of the economy. As capital chases asset classes, the characteristics of the assets may change and boundaries blur. But the rush of retirement savings will also spark the invention of new asset classes and structures, and will likely reenergize both old-fashioned annuities (which took off in the U.S. in the 1930s) and the more modern-day securitized products — sorely humbled but not destroyed by the financial crisis.
Capital flows are already choppy. In the past few years, in reaction to historically low interest rates, investors have moved en masse into dividend-yielding stocks, longer-duration bonds and high-yield assets. But in response to even small changes — a slow rise in interest rates, say — they could change course once again. “We could have massive dislocations as people quickly change their personal asset allocations,” says Scott Shay, a founder of Ranieri Partners Management in New York and the chairman of Signature Bank.
Competing pressures face aging baby boomers and those investing for the group’s retirement. On the one hand, there is the classic need as an investor ages to grow more conservative and risk-averse, to favor, all things being equal, bonds over stocks. On the other hand, in today’s near-zero-interest-rate environment, there is an increasingly intense (on occasion desperate) search for yield, which has of late ignited high-yield, real estate investment trust and corporate bond markets.
On a deeper level, retirement investors, like all long-term investors, understand that many of their long-held assumptions have been upended by the financial crisis. They focus particularly on the notable weaknesses exposed in the model of endowment investing pioneered by David Swensen of Yale University and imitated by his often less sophisticated followers.
Josh Lerner, a professor of investment banking at Harvard Business School, has studied how Swensen’s model has evolved, as well as disappointed, over the years. The Yale CIO’s approach, which stresses diversification into all types of equities and employs huge allocations to alternative assets, including private equity, venture capital, real estate, commodities and hedge funds, generated a 10.6 percent average annual return for the university’s endowment for the ten years ended June 30, 2012.
Eager to replicate those handsome returns, other endowments, as well as pension funds, followed Swensen’s lead and deployed similar strategies. Inevitably, though, the flood of money depressed returns for many of Swensen’s followers. Significantly, the promise of alternative assets — the group historically has not correlated with publicly traded equities — proved false in the dark days of the global financial crisis. In a flight to safety, investors bought U.S. Treasury bonds and not much else. Almost every asset class was hammered.
That’s one reason endowment performance dramatically deteriorated during the crisis and has remained subpar in recent years. According to a study by the Commonfund Institute and the National Association of College and University Business Officers, which represents the endowments of 2,500 colleges and universities, 823 endowments posted an average annual return of 5.6 percent for the ten years ended June 30, 2011. In preliminary results for 2012, endowments dropped 0.3 percent, on average.
Today smart long-term investors know that no rule is written in stone. “If you take a by-the-book approach, you’re less likely to succeed,” Lerner says. “Because the book will change. That’s assured.”
DEMOGRAPHERS CALL THE BABY BOOM generation the pig in the python because the horde so dramatically changed the course of U.S. population growth.
Baby boomers came of age in the halcyon postwar U.S. economy: steady growth (except for the nasty recessions of 1973–’75 and 1981–’82), modest inflation (except for the double-digit inflation of the late 1970s) and a rising standard of living, along with good-paying factory jobs, affordable college tuition, the promise of a defined benefit pension and, not least, income inequality that looks mild by today’s standards.
The strong economic growth that the U.S. experienced from the 1960s to 2000 was in many ways powered by the life experience of the baby boomers. That’s the conclusion of a 2012 paper titled “Demographic Changes, Financial Markets, and the Economy” by Robert Arnott and Denis Chaves, published in the Financial Analysts Journal. In the 1960s, when the leading edge of boomers was between the ages of 15 and 25, they kicked off a substantial marginal boost in productivity as they entered the workforce; they continued to deliver big productivity gains as 25- to 35-year-olds and 35- to 45-year-olds. Although there isn’t meaningful productivity growth in workers from 45 to 55, productivity doesn’t start to fall off until they are between 55 and 65.
If the baby boom generation was the face of postwar prosperity, it was also the engine fueling the great bull market in equities that ran from 1982 to 2000. Between July 1982 and August 2000, the Standard & Poor’s 500 Index rose an average annual 15.6 percent, while 30-year bonds averaged 8.8 percent.
Baby boomers started getting serious about their retirements as they entered middle age, with the oldest members of the group turning 40 in 1986. When they experienced the adrenalin high of double-digit stock returns, they poured even more money into the markets. In 1985 individuals held $750 billion in IRA and defined contribution plans; by the market peak in 2007, that number had rocketed to $9.2 trillion, according to the Investment Company Institute.
Financial markets zig and zag in response to demand for their assets. In the 1980s bull market, price-earnings multiples of companies in the S&P stock index doubled; P/Es doubled again in the 1990s. Earnings of the companies climbed about 6 percent a year, while the stock prices increased 14 percent annually. That multiple expansion reflected in large part the supply-demand imbalance that occurred when baby boomers started investing for their retirements.
The specter of increased longevity requires that investors save even more money to meet their retirement goals. Indeed, if mortality rates fall 1 percent per year below their expected trend, the cost to a defined benefit plan of providing an inflation-linked pension to a 45-year-old preretiree rises 11 percent, according to Guy Coughlan, chief risk and analytics officer of Pacific Global Advisors in New York. Coughlan created the first product that transferred longevity risk from an insurance company to the capital markets when he worked at J.P. Morgan in 2008.
Many academics and investment practitioners suggest that equities will be depressed for years as baby boom investors and the asset managers handling their retirement plans sell off some of their riskier assets and buy more-conservative bonds, hedged strategies and annuities. Again the laws of supply and demand kick in. Just as the P/E ratios on stocks expanded during the boomers’ peak earning years, they will contract until 2021, according to Zheng Liu and Mark Spiegel, a research adviser and a vice president, respectively, in the economic research department of the Federal Reserve Bank of San Francisco. Real stock prices will decline in aggregate by 13 percent, they predict.
Baby boomers looking to become more conservative investors have already sent record amounts of cash to bond funds. Investors have put $700 billion into taxable bond funds in the past five years, more than they allocated to equity funds at the height of the technology bubble in the late 1990s, according to Morningstar. While the Federal Reserve’s aggressive monetary policy has kept interest rates close to zero, the flood of money from investors chasing fixed-income securities has also helped keep a lid on rates. As money managers are being forced to buy almost any new corporate issue, many investors will likely find they bought securities at record-high prices, locking in low returns.
As investors and asset managers develop new strategies for retirement investing, their choices will buffet markets. How that will play out — which players, asset classes and strategies will prevail and which will retreat — remains to be seen.
Market observers offer a host of provocative theories.
Demand from retirement investors shopping for products with yield could reignite securitization, even as the Dodd-Frank Wall Street Reform and Consumer Protection Act and Basel III regulations are pushing banks and other financial institutions to reduce the amount of risk they take on. “There will be a new renaissance in securitization,” says Andrew Lo, a finance professor at the MIT Sloan School of Management and the director of Sloan’s Laboratory for Financial Engineering.
Recently, investors have been getting together to design and structure so-called bespoke, nonregistered securitizations, making club deals that bypass Wall Street firms altogether. Similarly, money managers are getting more involved with companies to structure debt and other securities now that investment banks are shrinking and paring back their staffs. “You’ll need to be a big investor to do [bespoke securitization],” says Ranieri Partners’ Shay. “The smaller hedge funds that used to be able to heavily rely on a third-party broker-dealer to structure deals for them will be history.”
In the new retirement landscape, insurers and money managers may also offer more-innovative annuities as well as structured products that minimize downside risk but offer newly defined upside potential.
Retirement market moves will be affected by federal policy decisions on Social Security and Medicare. If, for example, Social Security becomes means-tested in a way that eliminates benefits to retirees above a certain income level, those upper-income retirees and preretirees may choose to buy even more fixed-income instruments to mimic the steadiness of a regular paycheck from the government.
André Perold, professor emeritus of finance and banking at Harvard Business School and CIO of HighVista Strategies, an endowment management firm, sees another knock-on effect of a changing environment for retirement investment: Companies will restructure themselves in such a way that they will issue more debt and buy back more shares. “Corporations will change their capital structure, and older people will buy the debt and younger ones the riskier equities,” Perold says. “If changing demographics create price pressures, markets will respond.”
Lo also believes that markets are adaptive, by which he means that they are neither always efficient nor always irrational. Instead, they evolve, particularly when investors share the same goals and information. Though Lo says the Adaptive Market Hypothesis, which he first published in Institutional Investor’s Journal of Portfolio Management in 2004, is in its early days, it has already made an impact on portfolio management. “Investment strategies wax and wane to some degree, but beyond some threshold of assets under management, alphas are transformed into betas,” he wrote in a 2010 op-ed in the JPM. “Portfolio diversification is still a good idea, but now much harder to obtain because of how quickly and competitively markets adapt.”
For an indication of how markets have adapted and how difficult it can be to attain portfolio diversification, consider the recent history of endowment portfolio management, along with that of retirement planning, the other leading form of long-term investing.
Managers of university endowments thought they had discovered a reliable system for creating long-term above-market returns with manageable risk. The story began in 1985, when Yale hired Swensen, a former student of Nobel Prize–winning Yale economist James Tobin, to manage its endowment. Swensen started loading up on alternative assets like private equity and hedge funds, which were arcane at that time for university portfolios. He believed they would provide diversification and the chance for big returns by exploiting opaque parts of the market. By the mid-1990s one fifth of the Yale endowment was invested in hedge funds.
Rival Harvard quickly adopted Swensen’s model, hiring Jack Meyer in 1990. Loading up on alternative assets — timber and commodities as well as hedge funds — he delivered double-digit returns over the course of his 16-year tenure.
Other university endowments followed Yale and Harvard’s example, particularly after the technology bubble burst in 2000 and it became apparent that the Ivy League schools had avoided huge losses through their exposure to so-called noncorrelated assets like real estate, private equity and hedge funds. But investors running behind Yale and Harvard’s leadership typically got shut out of the best hedge funds and private equity portfolios. They opted for second-tier players, thinking they merely needed exposure to alternative assets, not necessarily to the most skilled managers.
Then Lehman Brothers Holdings went bankrupt in 2008, and the financial crisis erupted. Yale’s endowment lost 25 percent in the fiscal year ended June 30, 2009. No single cause explained that performance, but certainly the three core principles of Swensen’s model — active management, diversification, a willingness to trade liquidity for the chance of higher returns — didn’t work as expected.
In the wake of the financial crisis, many endowments and pension funds have made significant changes to their portfolios, including selling off private equity stakes in underperforming funds, implementing more-comprehensive risk management systems and redoubling efforts to find top-tier managers.
A worthy ideal, the endowment model proved a disappointment after it had been widely imitated by university portfolio managers chasing the same goal: a reliable stream of income to help fund college budgets, meaningful capital appreciation and appropriate levels of risk. Similarly, retirement investors share the same basic goal of producing solid returns to meet the needs of a long period of not working, stable assets to protect against downturns, and steady income. As investors pursue the same targets and adopt similar investment styles, the capital flows coming into the markets will recalibrate what they can expect to earn.
Arnott, Chaves and Christopher Brightman, head of investment management at Research Affiliates in Newport Beach, California, consider retirement investment through the prism of baby boomers, continued low interest rates and economic growth. Whereas a rising employment rate added 0.3 percent per year to GDP growth from 1950 through 2000, Brightman says, the demographic effect on the employment ratio will subtract 0.2 percent per year for the next two decades. While the population will be growing by 0.7 percent per year, the employable workforce will be increasing by only about 0.5 percent per year.
“The labor force will be growing more slowly than population growth,” says Brightman, adding drily that “aging baby boomers will be leaving the labor force but not dying. That’s the mirror image of the powerful economic growth they fueled when they started entering the labor force in their youth.” Then, the labor force was growing faster than the population at large.
Examining the low interest rates facing baby boomers planning for their retirements, Brightman asserts that slim investment yields are the market mechanism to alert baby boomers that they can’t consume at their expected level while at the same time not producing any goods and services themselves. He believes that demography explains 30 percent of the forces driving down interest rates, which of course also reflect monetary policy and powerful global macroeconomic factors. “The impact of demographics is that yields will be low in both bond markets and the stock markets for a very long time,” Brightman says. “Many will realize they have to play catch-up, and they’ll start competing for yield-producing assets. That will push prices up and lower yields further.”
Brightman predicts there will be little difference in the future risk premium for stocks — that is, the difference between the expected return of stocks versus bonds — but both asset classes will be depressed. He expects a –1 percent real return on bonds and a 2 or 3 percent real return on equities, putting expected annual returns for a portfolio with 60 percent of its assets in stocks and 40 percent in bonds at between 4 and 5 percent. That compares with a 9 percent average annual return over the past 20 years.
With a plain-vanilla portfolio offering so little, investors will turn to alternative investments for a chance of market-beating returns. But the rush of the crowd will make that prize ever more elusive.
“We’re more focused on and concerned about the flow of capital toward alternatives and to specific strategies like the carry trade and tail-risk hedging,” says Mark Carhart, chief investment officer of Kepos Capital, a New York alternatives firm focused on quantitative macro investing, and former co-CIO of Goldman Sachs Asset Management’s quantitative investment strategies group.
Carhart saw firsthand how massive inflows to quant funds proved problematic. As the credit bubble expanded, mathematicians and financial engineers developed computer programs to systematically make money off market anomalies. That all came to a halt in August 2007, when quant strategies collided with one another and many computer algorithms were revealed to be similar, using the same academic research and buying and selling the same small group of stocks at the same price signals. Goldman’s Global Alpha fund, which Carhart co-managed, lost 40 percent in 2007. “The simplest quant strategies can be copied, so pension funds, broker-dealers and asset managers started pushing on the same stocks,” says Carhart. “It got crowded.”
Carhart is now developing models that he expects can adapt more quickly to market conditions. Managers need to constantly refresh their research and have a deep understanding of market dynamics, he says.
Adding new pressure to the alternative asset class, according to Harvard’s Lerner, are pools of savers in emerging economies. In September, Lerner visited Queensland Investment Corp., the third-largest manager in Australia, to discuss alternative investments. He estimates that Australian institutions have only about 6 percent of their assets in alternatives. That compares with a 53 percent stake by U.S. endowments and a 20 percent stake by U.S. pension funds.
Individual investors could also have a big impact on capital flows into alternatives. Many will gain access through their defined contribution plans or even through increasingly popular target date funds that wrap multiple asset classes into one fund. AQR Capital Management, Neuberger Berman and other asset managers have been launching mutual funds that use alternative strategies. Financial research firm Cerulli Associates expects almost 10 percent of mutual funds to be in alternatives in five years, up from almost 3 percent today. Putnam Investments CEO Robert Reynolds, who built Fidelity Investments’ retirement platform, acknowledges that endowments have confronted problems with alternatives, but he believes such investments can be an important way to lower volatility. “You have to be in investments that are less volatile but still provide returns,” he says. “You can’t do it in fixed income alone.”
Small-cap stocks could be transformed by new retirement capital flows. The sector has gotten a recent boost because target date funds and other advisory programs automatically allocate part of their portfolios to this group of stocks. Even as investors have made net redemptions of shares of individual small-cap mutual funds over the past five years, they have invested five times as much money in target date funds in the same period. Assuming that such funds allocate, on average, 8 percent of total assets to small-cap equities, investors have indirectly put $25 billion to work in the sector through target date funds.
IF INVESTORS REMAIN STUCK in a world of low interest rates for the foreseeable future — even if the rates rise from their current lows, they could still be quite meager by historical standards — that painful reality may spur the biggest changes in capital markets.
Advisers have long preached to retirees that they can earn 5 to 7 percent a year off a mostly fixed-income portfolio. People saved with the intention of living off the interest and mostly not touching the principal.
As that strategy becomes increasingly untenable, investors have been moving into dividend-yielding stocks, longer-duration bonds, high-yield bonds, preferred securities, infrastructure investments and commercial real estate to fill the need for greater income. One possible side effect, economist Sharpe says: Interest in infrastructure could fuel the development of roads, bridges and tunnels in emerging markets or prompt governments to establish publicly traded companies to manage them. “If people want to invest in infrastructure for the income, they bid up the price,” says Sharpe. “That is, of course, a signal to build more toll roads.”
For some investors these income-producing products are a second-string investment choice. They don’t necessarily want to own the securities, but they feel they have no choice if they want to secure a base level of yield. When and if rates rise, these investors could move quickly out of these asset classes.
As a result, says Ranieri Partners’ Shay, market movements in the retirement space will be more dramatic than ever, particularly as many individuals are making their own decisions about their 401(k) portfolios.
What’s interesting about today’s situation, as Shay describes it, is how the makeup of the market — where people are investing and how securities are being structured — can be so distorted by rates or investors’ goals. During the past 50 years, investors’ market aims were more diverse. Some were aggressive; many were conservative. Given today’s overarching goal of retirement, that diversity has given way to more homogeneity and investors’ scrambling for similar assets. “Too many people are doing the same thing in their 401(k) and IRA portfolios,” says Shay.
Another potential effect of new approaches to retirement investing: Investors may increasingly look to emerging markets for both local companies that can capitalize on growth and for a supply of fixed-income products. Though savvy investors have been putting their money in many of these markets for years, allocations still remain relatively low — just 5 percent of U.S. pension plans.
Exchange-traded funds give investors easy access to new markets, including frontier markets, says Robert Kapito, president of BlackRock, whose iShares ETFs have the largest market share. “We’re giving clients access to all types of markets that they didn’t have access to before,” he says. As more and more corporate defined benefit plans match the duration of their assets to their liabilities — in part because companies are required to report pension values on their balance sheets under the Pension Protection Act of 2006 and new accounting rules— their choices will have a growing impact on overall retirement investing.
Asset-liability matching gives corporate pension plans a basic incentive to add long-duration corporate bonds. Many pension managers have not taken the bite in the current environment of superlow yields, says Anthony Gould, head of J.P. Morgan Asset Management’s pension asset liability solutions group. “But if yields go up sharply, we’ll see the double whammy of a slowdown in issuance and an increase in demand,” he says.
J.P. Morgan expects CFOs and CIOs of corporate pension plans to allocate almost 80 percent of the $2.3 trillion in corporate pension assets to fixed income, up from 40 percent today, in the next ten years. That will add $1.2 trillion, or more than $100 billion a year, in demand for long-duration assets. Corporate pension funds will be competing for about $150 billion in annual new issuance with insurers and retail investors, putting more pressure on bond prices.
Michael Moran, pension strategist at GSAM, notes that corporations have issued debt because today’s rates are so enticing. They then turn around and contribute cash to their pension funds. “Then another pension fund buys that debt. We’re all trading paper,” he says.
Finance and investing experts, when discussing retirement, easily slip into actuarial-speak about “table risk” — the tables outlining when people are likely to die — and mortality improvements. What’s lost in the conversation is how people might reimagine how they will choose to live their lives. Funding a 30- or 40-year retirement may be mathematically impossible for many.
Sharpe is a big believer that people will have to work longer. But he also believes that production — GDP — has to be equitably split between retirees and working people. “Society has to choose how to allocate goods and services,” says Sharpe. Based on current demographic trends, he says, “You can’t take enough from those who are working in the next generation to support those who are retired.” He asserts that every generation may have to work five years longer than the previous one.
Sharpe’s research on investing strategies in retirement, to which he plans to devote the rest of his life, also points to retirees having to share some of the risk of longevity, particularly as a larger proportion of a country’s population is retired. In the old days, when defined benefit plans were commonplace, pensioners received a guaranteed income for life, putting too much pressure on the succeeding generations.
Sharing the risk may mean that individuals will be required to buy insurance company annuities or other structured products. With an annuity an investor turns over, say, $1 million in exchange for a lifetime income determined by interest rates at the time. “If you don’t buy an annuity, you may have to spend your money very, very slowly to have enough to live until 100,” Sharpe says. “By pooling longevity risks, there can be major gains.” He acknowledges that investors are often scared away from annuities by high fees and the risk that an insurance company could go bankrupt. Also, people often resist the possibility that they may die before they get their money’s worth.
Sharpe has written a computer program using simulations to model the range of outcomes, total fees and other variations of retirement products available to investors.
Though Sharpe knows as well as anyone how economic models can fail to predict the future, he has been surprised nonetheless by the uncertainty inherent in any attempt to model investors’ incomes during lifetimes that may stretch over decades. Long-held beliefs like the 4 percent rule, which advised retirees to take out 4 percent of their portfolios plus a kicker for inflation each year, no longer seem secure, Sharpe says, “and can be wasteful and inefficient.”
“So you have this nice, smooth real income, unless you run out of money before you die,” he adds.
Of course, it helps the cause to stave off retirement as long as possible, and Sharpe is nothing if not busy. When he’s not mired in his retirement models, he helps his wife, Kathy, a painter and owner of a gallery in Carmel. Recently a potential customer stopped by and inquired about the gallery owner’s husband. A Scottish actuary was interested in meeting the Nobel Prize winner. • •
